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The spreads for Europe’s economically weak peripheries over equivalent German bonds—the European benchmark—continue to approach their pre-bailout highs. The 10Y spread in Spain again reached record levels amidst rumors that IMF, EU and the U.S. Treasury may be creating a EUR250bn credit line for the country (so far the EU and the Treasury department have denied the report). This coming Friday the head of the IMF, Dominique Strauss-Khan, is scheduled to meet with Spanish Prime Minister to discuss, “structural reform measures the government is undertaking, the labour reform to be approved tomorrow by the cabinet, and other measures to tackle the deficit, as well as measures by other countries and other economic zones.” Spanish officials have indicated that these meetings were scheduled prior to reports of a Spanish bailout. But, in the minds of some investors this visit is too coincidental, echoing a similar visit by the IMF to Greece just prior to that country’s own demise.

Amidst this strife, Spain is expected to auction 10Y and 30Y government bonds tomorrow totaling an estimated EUR3.5bn. This auction will be watched closely by investors, and any signs of weakness could spell trouble for Spain, Europe and any global risk correlated assets. Here is a complete list from Barclays of expected European bond auctions for the remainder of the week:

European equity markets and the Eurozone currency look to be pricing in separate outlooks for the future of the Eurozone after an unprecedented rescue package. As the chart below highlights, European equities as tracked by the MSCI European index has rebounded sharply from its pre-bailout low–surely aided by the ECB’s recent actions–, while the Euro has gone on to set a new interim low. Many view the bailout as a temporary fix to a much deeper problem that can only be solved with through harsh continent wide austerity plans—if even then. If Europe manages to somehow seamlessly enact these cuts, many nations have dug themselves so deep into debt that the slightest hint of a missed number, or even worse a failed debt auction has the potential to derail the entire process; quickly leading investors away from risk. While the Euro seems to be pricing in this possibility equities do not. This analysis doesn’t even mention the impact austere policies will have on the European growth outlook, which could also weigh on equities.

This piece is simply an updated version to a piece I published back on March 5th 2008 titled ‘How will it end’. Despite the fact we are much deeper into this financial crisis; the root of the problem has not changed, and that is the US housing market.

As an interesting exercise consider that in March 2007 the total value of US subprime mortgage market was estimated at USD1.3trn; now lets combine that with the fact that 12% of these mortgages have or are in the process of defaulting. What this implies is that the total value of subprime mortgages effected by these foreclosures equals USD156bn. Now compare that to the cost of write-downs (~USD517bn) and the Fed’s bailouts (USD85bn just for AIG)… Of course no one, including the Fed, could have possibly predicted the detrimental wide-spread effect the housing crisis would have on the global economy; my point is solely to demonstrate how a small piece can have a very significant impact on the entire picture in an over simplified manner.

Here it is with updated data and some small changes!

We are continuously being barraged with mixed news concerning the housing crisis. One day we hear signs are pointing towards a bottom; the next housing numbers came in much lower than expectations.So we raise this question: What indicators should we be looking at to truly signal a recovery in housing?

With this question in mind our analysis focused on creating the stages we believe would be necessary to facilitate a recovery.We were able to define 7 chronological stages which need to occur in order for the crisis to end. Additionally, the progress for each of the stages can be measured by several key indicators.The stages we outline below are meant to help to average investor better understand how a recovery will most likely unfold, and includes indicator that anyone with a basic internet connection will be able to easily access.

Foreclosures as a percent of total mortgages continue to rise…Source: Bloomberg

2.Banks need to lower lending standards for home mortgages.This will allow existing and new home sales to increase and prices to stabilize. Key Indicator(s):Fed Senior Loan Officer Survey, mortgage rates, Case Shiller Home price index (monthly), & New and Existing home sale prices

However, lending standards have tightened across all mortgage types according to the Senior Loan Officer Survey

3. Once people are again able to buy homes we will see a reduction in inventory levels.When this occurs demand will rise for new constructions. Key Indicator(s):New home sales data (monthly) & Existing home sales data (monthly)

But for now increased foreclosures and tighter lending standards have caused new home sales to drop

Source: Census

The recent crisis has begun to negatively effect the housing affordability indexSource: Bloomberg

4. The rise in demand for new construction will first show up in building permits.The rise in building permits will lead to our next step… Key Indicator(s):Building permits data (monthly)

But, building permits have shown no signs of a sustained recovery

Source: Census

5.Very soon after the rise in building permits we will see an increase in housing starts.Key Indicator(s):Housing starts data (monthly)

However, with permits still depressed, starts have shown no signs of recovery

Source: Census

6.The increase in starts will lead to an increase in construction spending. Key Indicator(s):Construction Spending (monthly)

Essentially, this crisis is occurring due to a substantial increase in the supply of houses through subprime foreclosures, and a decrease in demand to buy houses through harder to get mortgages.As more homes enter the market and less people are able to acquire mortgages to by them the price drops.Hence, the first major step in a recovery for the sector will be a slow-down in the number of foreclosures, which has likely been pushed back until second half 2009.Secondly, and equally important banks need to reduce lending standards to allow qualified buyers to purchase new homes.These two actions combined will begin to reduce the inventory of homes on the market and stabilize price.Once the amount of inventory of homes for sale begins to drop, we will see demand for new constructions begin to rise.This will first show up in the building permits index, followed by housing starts, and finally private construction spending.All in all, this will not be a fast process, with the reduction in foreclosures and lowering of lending standards being the hardest hurdle to overcome.

Currently, the primary driver for subprime foreclosures are interest rate resets.When these borrowers we first given their mortgages they were given low teaser rates which would eventually reset into higher adjustable rates.Meaning some mortgage holders who were paying USD1,200 a month for their mortgage in November could be paying USD3,200 a month in December.For a lot of these borrowers it has been nearly impossible to pay the new amount and they have been forced to default.On a positive note, based on available market information we should see the number of resets for adjustable rate subprime mortgages peak sometime in late spring/early summer.However, it is tough to estimate the lag time between mortgage resets and actual foreclosures, which prolong this situation. The deteriorating employment situation in the US will add additional downward pressure to this indicator. All in all there is no quick easy fix on the housing front, and we will likely have to deal with these conditions for quite some time.

Investment Idea:Once a the market starts showing signs of a sustained recovery we feel that US home builders could significantly benefit. US homebuilder stocks have been pounded since the housing crisis first began, and will be poised to make a recovery as demand for new homes eventually rises. However, as we said this could take some time, but it will happen. I currently hold a long position in ITB, a US home builder ETF.

Contact Me:

Michael.McDonough@fiateconomics.com
Michael is an economist/strategist who has worked from Wall Street to Hong Kong primarily focusing on the U.S. and emerging markets. He has also written several columns. More

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